Getting a real returns paradigm2 min read . Updated: 11 Aug 2014, 04:17 PM IST
Indian investors squirrel away money because they fear long-term inflation
In the recent controversies regarding the change in taxation for debt mutual funds, one point that was not widely discussed was that of the concept of real returns versus nominal returns.
The argument of the finance minister was that companies and others were taking advantage of a loophole and were paying taxes lower than those applicable on bank deposits. There can be no argument on this. Mutual funds were much more tax efficient when it came to debt investments. However, the main point is that the tax treatment of mutual funds wasn’t too liberal, but that on bank deposits is too onerous.
To understand this, it is important to understand the concept of income. This is simple for, say, a salaried employee, whatever salary comes at the end of the month is income (adjusted for provident fund and others). But when it comes to income from investments, the situation is somewhat complicated. The entire interest that is credited in the bank account is not income in the true sense. This is especially true in high inflation countries like India. Say, you have a ₹ 100,000 fixed deposit, which pays you ₹ 9,000 interest in one year. In that same year, if the inflation is at 9%, effectively, you have just maintained your purchasing power rather than getting an “income" of ₹ 9,000.
In financial literature, the income denominated in currency, like the interest earned of ₹ 9,000, is called the nominal income, whereas income denominated in terms of purchasing power is called real income.
The indexation benefit that mutual funds were giving were effectively taxing only the real income portion and not the nominal income.
Getting a real return paradigm is very important when planning for the future. Hence, saying that I will need ₹ 1 crore for my child’s education 10 years from now is meaningless unless one knows what will be the level of inflation over the next 10 years.
Successive finance ministry and Reserve Bank of India officials have ridiculed the Indian habit of squirreling away savings into gold and into real assets such as property. In their view, this is a very foolish thing to do. The fact of the matter is that implicitly the Indian saver does not trust the officials to keep inflation under check and to provide post-tax positive real returns on savings. When it comes to equities, the corporate mis-governance of the past and the malpractices of financial intermediaries are stumbling blocks.
Much has been done over the years to improve the investing environment. Establishment of a regulator in the form of Securities and Exchange Board of India, depository for shares, screen-based trading, clearing corporations, settlement guarantee fund, rolling settlements, disclosure norms for companies, and so on.
However, many things remain to be achieved. If I had to name just three, these would be:
• Strong corporate governance. We cannot have scams like Satyam or Winsome Diamonds happening regularly in the market.
• Financial intermediaries behaving themselves, whether it is in mutual funds, banks, insurance, brokerages, merchant banking or distribution, and keeping the client’s interest first.
• Finally, control on inflation to assure investors of a positive real return from financial instruments in the long run.
Indian investors may not be financially sophisticated but have intuitively figured out what inflation does to their wealth.
The author is chief investment officer and equity fund manager, PPFAS Asset Management Pvt. Ltd.